Special Problems in Valuation

1
Special Problems in Valuation
2
A Valuation outside the U.S.
3
How to value foreign assets for US investors?

• Approach 1 Valuing the companies in terms of
  the foreign currency
• Project all the FCF in foreign currency
• Discount those cash flows back to present using
  the foreign currency-based WACC.
• Convert the final value back to USD using the
  current spot exchange rate.
• only one exchange rate (current spot) needed
• -- foreign currency-based WACCs are more
  difficult to estimate

4
How to value foreign assets for US investors?

• Approach 2 Valuing the companies in terms of
  USD
• Project all the FCF in USD, immediately
  expressing all the local currency figures in USD
  using the time series of expected (forward)
  exchange rates for each of particular future
  years
• Discount those cash flows back to present using
  the dollar-based WACC.
• dollar-based WACCs are easier to estimate
• for US investors, dollar figures are easier to
  understand and compare
• -- a whole time series of forward exchange rates
  is needed to estimate FCF in terms of USD. For
  many foreign currencies, such long time series
  will not likely be available.

5
Why estimations are not so easy outside the U.S.?

• Government rates in foreign countries may be far
  from risk-free
• There can be additional country premiums that
  should be added to the market risk premium
• Measures of risk (e.g. Betas) are imprecise
  and/or impossible to compute (this can easily
  happen in the U.S. as well)

6
Cost of Equity outside the U.S.

• Dollar-based CAPM for valuation of foreign assets
• RE Risk-free rate (U.S.) ß U.S.
  Market-Risk Premium Country Equity Premium
• where U.S. MRP (typically) 5.50
• Country Equity Premium Country (bond) default
  spread ?Country Equity / ?Country
  Bond
• Remarks
• Country bond default spread should be measured
  for dollar-denominated governmental debt
• Since ?Country Equity / ?Country Bond is often
  difficult to measure for many foreign countries,
  analysts often use the ratio 1.5
• Parameter values for many countries can be
  obtained at damodaran.com

7
Cost of Debt outside the U.S.

• Ideally, we would like to have info on the
  companys debt YTM or companys credit rating,
  but
• A vast majority of companies in less developed
  markets will not have such information available!
• Thus, the syntetic rating (typically based on
  companys leverage and/or interest rate coverage
  EBIT/Interest Expense) will be a very frequently
  used method for estimation of cost of debt for
  the companies outside the U.S.
• Cost of Debtforeign company Riskless rate
  (i.e. US T.Bond) Country bond default spread
  Company Default Spreadsyntetic rating
• where Country bond default spread is measured
  as the default spread of dollar-denominated bonds
  issued by the country

8
Forecasting future exchange rates

• Interest rate parity
• Xft forward exchange rate (foreign/domestic)
  at time t
• X0 spot exchange rate (foreign/domestic)
• NF nominal foreign governmental interest rate
• ND nominal domestic governmental interest rate
• Xft X0 (1NF)/(1ND)t

9
Forecasting Future Exchange Rates - Example
10
Forecasting future exchange rates alternative
approach

• Interest rate parity
• Xft Expected future exchange rate
  (foreign/domestic) at time t
• X0 spot exchange rate (foreign/domestic)
• iF expected inflation - foreign
• iD expected inflation - domestic
• Xft X0 (1iF)/(1iD)t

11
Forecasting Future Exchange Rates - Example
12
B Valuation of Private Companies
13
Whats so special about private companies?

• The traditional valuation principles (discounted
  cash flows, valuation using multiples) still hold
  for private companies (note Eatons, Oxford
  Learning were private companies), but
• Usually much smaller volume of accounting data we
  can work with when valuing a private company
  (disclosure requirements are smaller, companies
  tend to be younger)
• No price data (duh)
• Private owners tend to have more than the optimal
  fraction of their wealth invested in their
  private company (thus CAPM may not work
  perfectly)
• Absence of liquid trading means that purchase
  stakes tend to be substantially higher for
  private companies. Liquidating an equity position
  tends to be more difficult (and expensive).
  Valuing private company by private buyer may thus
  involve a liquidity discount.

14
Estimating Cost of Equity for a Private Firm

• Most models of risk and return (including the
  CAPM and the APM) use past prices of an asset to
  estimate its risk parameters (beta(s)).
• Private firms and divisions of firms are not
  traded, and thus do not have past prices.
• Thus, risk estimation has to be based upon an
  approach that does not require past prices

15
I. Comparable Firm Betas

• Collect a group of publicly traded comparable
  firms (pure plays), preferably in the same line
  of business, but more generally, affected by the
  same economic forces that affect the firm being
  valued.
• A Simple Test To see if the group of comparable
  firms is truly comparable, estimate a correlation
  between the revenues or operating income of the
  comparable firms and the firm being valued. If it
  is high (and positive), of course, your have
  comparable firms.
• If the private firm operates in more than one
  business line collect comparable firms for each
  business line

16
Estimating comparable firm betas

• Estimate the average beta for the publicly traded
  comparable firms.
• Estimate the average market value debt-equity
  ratio of these comparable firms, and calculate
  the unlevered beta for the business.
• ?unlevered ?levered / (1 (1 - tax rate)
  (Debt/Equity))
• Estimate a debt-equity ratio for the private
  firm, using one of two assumptions
• Assume that the private firm will move to the
  industry average debt ratio. The beta for the
  private firm will converge on the industry
  average beta.
• ??private firm ?unlevered (1 (1 - tax rate)
  (Industry Average Debt/Equity))
• Estimate the optimal debt ratio for the private
  firm, based upon its operating income and cost of
  capital.
• ??private firm ?unlevered (1 (1 - tax rate)
  (Optimal Debt/Equity))
• Estimate a cost of equity based upon this beta.

17
Estimating Beta for the NY Yankees (1999)

• You have three choices for comparable firms
• Firms that derive a significant portion of their
  revenues from baseball (Traded baseball teams,
  baseball cards memorabalia)
• Firms that derive a significant portion of their
  revenues from sports
• Firms that derive a significant portion of their
  revenues from entertainment.
• Comparable firms Levered Beta Unlevered Beta
• Baseball firms (2) 0.70 0.64
• Sports firms (22) 0.98 0.90
• Entertainment firms (91) 0.87 0.79
  Management target
• Levered Beta for Yankees 0.90 ( 1 (1-.4)
  (.25)) 1.04
• Cost of Equity 6.00 1.04 (4) 10.16

18
Is beta a good measure of risk for a private firm?

• Probably not
• The beta of a firm measures only market risk, and
  is based upon the assumption that the investor in
  the business is well diversified. Given that
  private firm owners often have all or the bulk of
  their wealth invested in the private business,
  their perceived cost of equity should therefore
  be higher than the costs of equity from using
  betas?

19
Total Risk versus Market Risk

• Adjust the beta to reflect total risk rather than
  market risk. This adjustment is a relatively
  simple one, since the correlation with the market
  measures the proportion of the risk that is
  market risk.
• Total Beta Market Beta / Correlation with
  market (se/ sm)
• In the New York Yankees example, where the
  market beta is 0.85 and the R-squared for
  comparable firms is 25 (correlation is therefore
  0.5),
• Total Unlevered Beta 0.90/0. 5 1.80
• Total Levered Beta 1.80 (1 (1-0.4)(0.25))
  2.07
• Total Cost of Equity 6 2.07 (4) 14.28
• HOWEVER, NOTE THAT THIS COST OF EQUITY ESTIMATE
  ASSUMES THAT THE BUYER WILL BE ANOTHER PRIVATE
  ENTITY!!!

20
Estimating the Cost of Debt for a Private Firm

• Basic Problem Private firms generally do not
  access public debt markets, and are therefore not
  rated.
• Most debt on the books is bank debt, and the
  interest expense on this debt might not reflect
  the rate at which they can borrow (especially if
  the bank debt is old.)
• Solution 1 Assume that the private firm can
  borrow at the same rate as similar firms (pure
  plays, probably in terms of size) in the
  industry.
• Cost of Debt for Private firm Cost of Debt for
  similar firms in the industry
• Solution 2 Estimate an appropriate imputed bond
  rating for the company, based upon financial
  ratios, and use the interest rate estimated bond
  rating.
• Cost of Debt for Private firm Interest Rate
  based upon estimated bond rating (If using
  optimal debt ratio, use corresponding rating)

21
Estimation Options for Cost of Debt

• Solution 3 If the debt on the books of the
  company is long term and recent, the cost of debt
  can be calculated using the interest expense and
  the debt outstanding.
• Cost of Debt for Private firm Interest Expense
  / Outstanding Debt
• If the firm borrowed the money towards the end of
  the financial year, the interest expenses for the
  year will not reflect the interest rate on the
  debt.
• For the Yankees, we will use the interest rate
  from the most recent loans that the firm has
  taken on
• Interest rate on debt 7.00
• After-tax cost of debt 7 (1-.4) 4.2

22
Estimating the Cost of Capital

• Basic problem The debt ratios for private firms
  are stated in book value terms, rather than
  market value. Furthermore, the debt ratio for a
  private firm that plans to go public might change
  as a consequence of that action.
• Solution 1 Assume that the private firm will
  move towards the industry average debt ratio.
• Debt Ratio for Private firm Industry Average
  Debt Ratio
• Solution 2 Assume that the private firm will
  move towards its optimal debt ratio.
• Debt Ratio for Private firm Optimal Debt Ratio
• Consistency in assumptions The debt ratio
  assumptions used to calculate the beta, the debt
  rating and the cost of capital weights should be
  consistent.

23
Estimating Costs of Capital for NY Yankees (1999)

• Cost of Equity 14.28(total beta)
• E/ (DE) 80.00
• Cost of Debt 7.00
• (1-T)Cost of Debt 4.20
• D/(DE) 20.00
• Cost of Capital 12.26

24
Estimating Cash Flows for a Private Firm

• Shorter history Private firms often have been
  around for much shorter time periods than most
  publicly traded firms. There is therefore less
  historical information available on them.
• Different Accounting Standards The accounting
  statements for private firms are often based upon
  different accounting standards than public firms,
  which operate under much tighter constraints on
  what to report and when to report.
• Intermingling of personal and business expenses
  In the case of private firms, some personal
  expenses may be reported as business expenses.
• Separating Salaries from Dividends It is
  difficult to tell where salaries end and
  dividends begin in a private firm, since they
  both end up with the owner.

25
Estimating Private Firm Cash Flows

• Restate earnings, if necessary, using consistent
  accounting standards.
• To get a measure of what is reasonable, look at
  profit margins of comparable publicly traded
  firms in the same business
• If any of the expenses are personal, estimate the
  income without these expenses.
• Estimate a reasonable salary based upon the
  services the owner provides the firm.

26
The Yankees Revenues

• Pittsburgh Pirates Baltimore Orioles New York
  Yankees
• Net Home Game Receipts 22,674,597
  47,353,792 52,000,000
• Road Receipts 1,613,172
  7,746,030 9,000,000
• Concessions Parking 3,755,965
  22,725,449 25,500,000
• National TV Revenues 15,000,000
  15,000,000 15,000,000
• Local TV Revenues 11,000,000
  18,183,000 90,000,000
• National Licensing 4,162,747
  3,050,949 6,000,000
• Stadium Advertising 100,000
  4,391,383 5,500,000
• Other Revenues 1,000,000
  9,200,000 6,000,000
• Total Revenues 59,306,481 127,650,602
  209,000,000

27
The Yankees Expenses

• Pittsburgh Pirates Baltimore Orioles New York
  Yankees
• Player Salaries 33,155,366
  62,771,482 91,000,000
• Team Operating Expenses 6,239,025
  6,803,907 7,853,000
• Player Development 8,136,551
  12,768,399 15,000,000
• Stadium Game Operations 5,270,986
  4,869,790 7,800,000
• Other Player Costs 2,551,000
  6,895,751 7,500,000
• G A Costs 6,167,617
  9,321,151 11,000,000
• Broadcasting 1,250,000
  - -
• Rent Amortization -
  6,252,151 -
  
• Total Operating Expenses 62,770,545
  109,682,631 140,153,000

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Adjustments to Operating Income

• Pittsburgh Pirates Baltimore Orioles New York
  Yankees
• Total Revenues 59,306,481 127,650,602 209,000,0
  00
• Total Operating Expenses62,770,545 109,682,631
  140,153,000
• EBIT -3,464,064 17,967,971 68,847,000
• Adjustments 1,500,000 2,200,000 4,500,000
• Adjusted EBIT -1,964,064 20,167,971 73,347,000
  
• Taxes (at 40) -785,626 8,067,189 29,338,800
• EBIT (1-tax rate) -1,178,439 12,100,783 44,008,
  200
• Typically, the adjustments for most of the
  private companies are consequences of personal
  expenses charged by the owner to the firm (or
  maybe salaries of the owners friends, etc.)

29
Estimating Cash Flows and Value for Yankees

• We will assume a 3 growth rate in perpetuity for
  operating income. To generate this growth, we
  will assume that the Yankees will earn 20 on
  their new investments (brand name, location,
  barriers to entry). This yields a reinvestment
  rate of
• Reinvestment rate g/ ROC 3/20 15
• Estimated Free Cash Flow to Firm
• EBIT (1- tax rate) 44,008,200
• - Reinvestment 6,601,230
• FCFF 37,406,970
• Estimated Value of Yankees
• Cost of capital 12.26 Expected Growth
  rate 3.00
• Value of Yankees 37,406,970
  (1.03)/(.1226-.03)
• 415,902,192 if valued by a private buyer

30
What if?

• We are assuming that the Yankees have to reinvest
  to generate growth. If they can get the city to
  pick up the tab, the value of the Yankees can be
  estimated as follows
• FCFF EBIT (1-t) - Reinvestment 44.008 mil -
  0 44.008 million
• Value of Yankees 44.0081.03/(.1226 - .03)
  489 million
• If on top of this, we assume that the buyer is a
  publicly traded firm and we use the market beta
  instead of the total beta
• FCFF 44.008 million
• Cost of capital 8.95
• Value of Yankees 44.008 (1.03) / (.0895 - .03)
  761.6 million

31
Value of NY Yankees through time

• Year Revenue EBITDA D/V() Value
• 1997 144.7 21.4 NA 362
• 1998 175.5 23.0 3 491
• 1999 195.6 17.5 47 548
• 2000 192.4 21.9 15 635
• 2001 215.0 18.7 7 752
• 2002 223.0 16.1 14 849
• ( millions, source Forbes Magazine)
• (The second most valuable team in the MLB, New
  York Mets, was worth 498 million in 2002)
• Yankees owner, George Steinbrenner, bought his
  team in 1973 for 10 million

32
Analyzing the Effect of Illiquidity on Value

• Investments which are less liquid should trade
  for less than otherwise similar investments which
  are more liquid.
• The size of the illiquidity discount should
  depend upon
• Type of Assets owned by the Firm The more liquid
  the assets owned by the firm, the lower should be
  the liquidity discount for the firm
• Size of the Firm The larger the firm, the
  smaller should be size of the liquidity discount.
• Health of the Firm Stock in healthier firms
  should sell for a smaller discount than stock in
  troubled firms.
• Cash Flow Generating Capacity Securities in
  firms which are generating large amounts of cash
  from operations should sell for a smaller
  discounts than securities in firms which do not
  generate large cash flows.
• Size of the Block The liquidity discount should
  increase with the size of the portion of the firm
  being sold.
• RULE OF THUMB TYPICAL ILLIQUIDITY DISCOUNTS
  RANGE BETWEEN 20-30 WITH LITTLE VARIATION
  ACROSS FIRMS